Accounting earnings and chief executive officer compensation: the joint effect of earnings' contracting and valuation roles

Abstract

This paper investigates the impact of accounting earnings on Chief Executive Officer (CEO) compensation by examining how the valuation role and the contracting role of accounting earnings jointly determine the value of CEO total compensation. Current earnings are informative about the firms future cash flows and hence affect stock price, and the resulting price movement affects the value of CEO equity-based compensation. Thus, accounting earnings not only have a direct impact on CEO cash compensation, but also an indirect impact on CEO equity-based compensation due to earnings valuation role. To my knowledge, this paper is the first to provide empirical evidence that because of earnings valuation role, accounting earnings are an economically significant determinant of CEO total compensation. Prior accounting research testing predictions of agent theory has focused on CEO cash compensation even though total compensation is a more relevant measure. Thus, the significant result of earnings in CEO total compensation enables re-examination of agency predictions. I provide evidence that earnings (but not stock returns) are used in CEO total compensation consistent with the sensitivity vs. precision hypothesis. That is, accounting earnings receive less weight when earnings are relatively more volatile and when firms have significant growth opportunities.